There are lots of options available for individuals when it comes to considering how to best fund their retirement. A major consideration is how to save on or defer your tax liability so your income can be maximized once its time to withdraw your earnings. Two of the the most utilized investment vehicles are the 401(k) Plan and the IRA. The 401(k) Plan is a pension plan arranged through an employer and an IRA is a private investment account. They both are designed for individuals to be able to save a portion of their salary or income for retirement, either tax free or tax deferred, but there are also some differences between them.
A 401(k) Plan is a retirement savings program that’s set up through an individual’s employer. A certain amount of your earnings are set aside during your regular pay periods. Also known as defined contribution plans, money is put away toward your retirement on a tax deferred basis. This means you won’t be required to pay state or federal taxes on any of the funds you have saved until you’re ready to make withdrawals. Since the money is taken out of your paycheck before taxes are withdrawn, it also lowers your taxable income and therefore lowers your taxes. Another advantage is that the average taxpayer will be paying a lower rate in taxes during their retirement years than when were employed. So even when it’s time to pay taxes on their withdrawals it will be less than when they were working. Another potential benefit is that some employers will match their employees’ contributions anywhere from 25 to 100 percent. There is a maximum amount the IRS allows you to contribute annually to your 401(k) and that amount is adjusted upward to account for inflation. This was 17,500 as of 2013.
There are a few risks associated with 401(k) investments. One is that you’re not given a way to clearly define how much money you’ll need to comfortable retire on. Also there may be various hidden fees for broker’s commissions and other services that may be taken out of your contributions that you may not be aware of. Plus early withdrawals can amount to severe penalties meaning you’ll be paying taxes on the amount you take out.
An IRA Plan, on the other hand, can opened by anyone through a financial institution that will handle management of the funds. There are actually three types of IRA accounts; Traditional, Roth and Rollover. With a Traditional IRA you make contributions with funds you may be able to deduct on your tax return. Those funds can continue to grow tax deferred until retirement age.
The Roth IRA contributions you make are with money you’ve already paid taxes on. The Rollover IRA is a Traditional IRA set up to have funds “rolled over” from an existing retirement account. For instance having 401(k) funds moved to an new IRA which would then be a Rollover.
One of the risks involved with an IRA is the penalty for converting from a Traditional to a Roth. In this case you’d be giving up the tax deferred status of the money originally deposited in the Traditional IRA. For instance if you rolled over 10,000 dollars in your IRA to a Roth you’d be responsible for adding that amount as taxable income for the year of the transfer. With a Roth IRA you also need to hold your funds in the account for a minimum of five years in order to avoid a ten percent penalty on earnings withdrawn.
Also your funds in your IRA will not be secure unless it is invested in a certificate of deposit or savings account. Both of these investments are FDIC insured and offer more consistent returns. If you’ve chosen instead to invest in a mutual fund, bonds or stocks it’s possible you can incur losses depending on market conditions. With both investments, 401(k) as well as IRA, you run the risk of paying penalties if you withdraw funds before age 59 1/2.
Choosing one investment vehicle over the other depends on whether or not you work for an employer that offers a 401(k) plan. Selecting an IRA is is more about finding what type is best for you as anyone can invest. Many individuals have both, since experts calculate that employee sponsored pensions may not offer enough income to completely fund many individuals’ expenses when they retire. Supplementing your 401(k) can also help since you’ll have a wider range of options for investments with an IRA.
In conclusion, if your employer offers a 401(k) Plan, take advantage of it. Even if you change jobs you’ll be able to switch it over. Consider an IRA if you don’t have that option or if you’re looking for a retirement program that has more flexibility regarding the type of investments you can choose.